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Crypto turns into a portfolio kryptonite
Virtual asset offers little benefit to institutional investors as diversifier, safe haven or inflation hedge, study finds
The Asset 19 May 2022

The recent collapse of the Terra stablecoin and its associated token Luna highlights the risks of investing in cryptocurrency. Investments worth billions of dollars were wiped out almost overnight after the algorithmic system supporting the crypto pair crumbled.

For PGIM, the investment management business of Prudential Financial, the latest blow to crypto investing supports its view that cryptocurrency is a “portfolio kryptonite” that offers little benefit to an institutional investor while adding considerable volatility and risk.

It is an unreliable portfolio diversifier and an inadequate safe-haven asset or inflation hedge, the firm says in a recent paper on industry megatrends, adding that recent risk-adjusted returns are not much different from other asset classes but with more frequent and greater drawdowns.

Beyond hedge funds exploiting inefficiencies to generate alpha on the other side of largely retail and speculative flows – mostly driven by a “fear of missing out” (FOMO) mentality – there is currently no compelling case for direct ownership of cryptocurrencies as a meaningful share of an institutional portfolio, PGIM says.

Three criteria

“As long-term investors and fiduciaries on behalf of our clients, three things need to be true for us to add an asset class into a portfolio: the asset needs a clear regulatory framework, it needs to be an effective store of value, and it needs to have a predictable correlation with other asset classes,” says PGIM chief executive officer David Hunt. “Cryptocurrency currently meets none of these three criteria. It’s much more of a speculation than an investment.”

Also, the unsettled regulatory backdrop and the significant environmental, social and governance (ESG) concerns over cryptocurrencies pose significant additional headwinds for long-term investors.

“Cryptocurrency may be a heroic quest to build a viable, decentralized peer-to-peer payment system, but its pricing is based on speculative behaviour, rather than a fundamental thesis around its value or utility,” adds PGIM head of thematic research Shehriyar Antia.

According to PGIM research, cryptocurrency is not an effective hedge against inflation. In 2021, the price of bitcoin and other cryptocurrencies moved with inflation only for a brief time before falling sharply. Gold, on the other hand, has demonstrated since the 1970s that it can be an effective and reliable inflation hedge.

Bitcoin, the most prevalent cryptocurrency, did not function as a safe-haven assets in early 2020 when global asset prices spiralled downwards in the wake of Covid-related shutdowns. It held far less of its value than conventional safe-haven assets.

The investment manager also asserts that cryptocurrencies clash with ESG objectives. A single transaction on the bitcoin blockchain is equivalent to two million transactions on the Visa network, or roughly the same energy needed to power the average American home for over two months. From a governance perspective, the difficulty in tracing the identity of its owners makes it a preferred medium of exchange in illicit activity – such as its potential for skirting sanctions in the wake of Russia’s invasion of Ukraine.

Blockchain applications

“Cryptocurrency gets all the breathless hype, but it’s the underlying technology where we find the most interesting investment opportunities,” says Taimur Hyat, PGIM chief operating officer. “Firms that enable real-world blockchain applications like clearing and settling transactions, preventing fraud, and tokenizing real assets offer significantly greater creation of value over the next decade. The old axiom applies – when there’s a gold rush, invest in shovels and pickaxes.”

Distributed ledger technology and smart contracts can revolutionize elements of financial services, logistics, and supply chain management, as they eliminate the need for counterparty and trade verification as well as transaction and record reconciliation, according to the study.

The tokenization of real estate and infrastructure assets could substantially reduce costs from transactions and servicing, increase liquidity, simplify transactions, enhance price transparency, and allow more granular portfolio construction.

Moreover, collateral innovation in areas such as fraud prevention, regulatory compliance and other key enablers of the broader crypto ecosystem has the potential to generate attractive returns for owners of the companies that provide such services.

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